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Calculating expected loss


JSand
Posts: 5
Topic starter
(@jsand)
Active Member
Joined: 8 months ago

Hi folks,

I'm thinking of using expected loss to compare risks across different strategies. I've seen some places calculate this as: [money at risk * delta (as approx of loss probability)]. But I think this is the wrong way because it assumes all of the money at risk has same probability of loss. 

So I think the correct way is: [sum across spread ( strike width * delta for this strike)]. For naked puts, add across strikes until delta is 0. 

As a sanity check, it correctly shows that a single 100k spread is less risky than 10 * 10k spreads. So seems like a quick way to compare the expected loss vs premium for different deltas and underlying. But wanted to get other's input. Does using expected loss (with the above formula) make sense as a way to compare risks?

1 Reply
earlyretirementnow.com
Posts: 294
(@earlyretirementnowcom)
Member
Joined: 6 years ago

I like the general idea, but it runs the risk of generating something of a tautological exercise. If you use the implied vol and then the implied probability distribution of the underlying at expiration you will likely find that the expected value of the option is equal to the price of the option.

Also, keep in mind that one of the attractions of the short-vol strategy is that realized vol is normally smaller than implied vol. Not all the time, but most of the time. So, any kind of risk model should rely on an external, independent risk estimate where you gauge the market vol independent of the implied vol. That independent risk estimate should be used to calculate the expected loss. 

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